Lowering interest may put upward pressure on inflation
AFTER SEVEN STRONG YEARS, IT'S NOT surprising that the US expansion that began in 1991 is showing signs of aging. Early indicators of slowing, along with continuing spillover effects of the Asian financial crisis, are creating expectations that the Federal Reserve might actually cut interest rates before the year is out. In our view, with the economy still operating above its long run potential, such a move would be a mistake.
Most forecasters expect economic growth for 1998 as a whole to be much weaker than the strong record of 3.8 percent for 1997, and some see the US economy heading into very weak growth of less than 2 percent in 1999. A number of indicators, such as the need to work off the large inventory build up in this year's first quarter, support these predictions.
In addition, there's concern that the economic collapse in Southeast Asia could lead to a global recession, with obvious significance for the US economy. It's true that reduced Asian demand for US exports will continue to slow growth here. But the accompanying increase in low-priced Asian imports has taken pressure off prices at a time when consumer prices have bean creeping up. On balance, the Asian crisis has reduced growth in the United States, but not enough to cause the Fed to change its course.
The benign view of a Federal Reserve decision to lower interest rates is that such a move would bring down the value of the US dollar and increase the competitiveness of American goods in world markets. It would be more effective and long lasting than the Treasury effort to lower the dollar by intervening in global currency markets to buy Japanese yen with US dollars.
The final piece of the case for cutting interest rates now is that real interest rates are actually quite high. The federal funds rate that the Federal Reserve directly controls and that acts as a measure of the Fed's monetary restrictiveness has been set at 5.5 percent for over a year. With consumer prices rising at only 1.5 percent, that 5.5 percent rate translates into a real rate of 4 percent, quite high in comparison to past years. The same conclusion applies to market-determined interest rates. The prime rate that banks charge their business customers is about 8.5 percent or a real rate of 7 percent, also quite high historically.
While these factors are all valid, the overriding reason to oppose a move to lower interest rates is that US labor markets remain very tight, putting potential upward pressure on inflation. Wages have been rising slowly but at an accelerating pace since 1995 when the unemployment rate first dropped below 6 percent, the traditional inflationary threshold.
Data show wages and salaries rising at 2.8 percent in 1994 and 1995, increasing to a 3.4 percent rise in 1996 and a 3.9 percent rise in 1997. In the first quarter of this year, wages increased at a 4 percent rate, a level that has not been seen since 1990. In addition, while the cost of health benefits had been kept tightly under control in the past several years as employers shifted to managed care plans, recent evidence suggests health benefit costs have turned around and will be rising more rapidly.
Indeed, without the influence of two special factors, it is likely that these wage increases would have worked their way into rising consumer prices before now. Unusually rapid productivity gains in 1996 and 1997 made it possible to pay higher wages without passing the cost on in higher prices. And, import costs have been falling as the dollar has risen and as the world price of oil has declined. Import prices are now 10 percent lower than they were at the end of 1995.
But while the strong dollar may continue, productivity gains have dropped in the nonfarm business sector back to an annual rate of 0.2 percent, compared to 1996's 1.9 percent and 1.7 percent in 1997. If labor markets continue to be very tight, it may not be possible to avoid faster increases in consumer prices. From the point of view of price stability and long term employment, a period of slower growth would be welcome.
We're also concerned by the recent rapid increases in the money supply. In the past, a rapid increase in the money supply has been a reliable precursor of inflation. In recent years, the link between the money supply and inflation has weakened and the Federal Reserve has reduced its emphasis on controlling the supply of money, basing its policy instead on the federal funds interest rate. But the Fed can hardly ignore the sharp rise in broad measures of the money supply. M2, the common measure of money that includes currency, checking deposits and money market funds, has been rising sharply. In 1995, M2 rose 4 percent; in 1997 it rose 5.6 percent and in the past 12 months has gone up 7 percent. A broader measure of money known as M3 has shot up from 6 percent in 1995 to more than 10 percent in the past 12 months.
Chairman Alan Greenspan has many times indicated that the goal of the Federal Reserve is to achieve price stability. The inflation figures of recent years have been as good as they get. But with the current high level of demand in the economy, there is a not negligible risk that inflation could be coining back. Barring some major new shock that would slow the economy the Fed should continue to leave well enough alone.
Martin Feldstein, the former chairman of the Council of Economic Advisers, and his wife, Kathleen, also an economist, write frequently together on economics.